The concept of financial innovation has fallen on hard times, but it’s a necessary tool for the economy, says Federal Reserve Chairman Ben Bernanke — so long as it’s accompanied by proper regulation. “Subprime mortgage loans, credit default swaps, structured investment vehicles, and other more-recently developed financial products have become emblematic of our present financial crisis,” said Bernanke today at a conference in Washington, D.C. “Indeed, innovation, once held up as the solution, is now more often than not perceived as the problem.” But it would be unwise to stop financial innovation, he said. However, he urged the nation be more alert to the risks associated with innovation and the need to manage those risks properly. According to Bernanke, certain questions about proposed innovations should be raised: For instance, how will the new product or practice perform under stressed financial conditions? And what effects will the innovation have on the ability and willingness of the lender to make loans that are well underwritten and serve the needs of the borrower? The challenge faced by regulators is to strike the right balance, he said. Regulators must strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit. “Our goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.” A number of factors play a part in the recent credit boom and bust, including problems stemming from financial innovation, Bernanke explained. From a consumer protection point of view, a particular concern for the Chairman and his team has been the sharp increase in the complexity of the financial products offered to consumers — complexity which has been a side effect of innovation but which also has in many cases been associated with reduced transparency and clarity in the products being offered. Mortgage products, for example, have become much more complex. “And, we have learned, loan features matter,” Bernanke said. Some studies of mortgage lending outcomes, after controlling for borrower characteristics, have found elevated levels of default associated with certain loan features, including adjustable rates and prepayment penalties, as well as with certain origination channels, including broker originations. “Although these results are not conclusive, they suggest that complexity may diminish consumers’ ability to identify products appropriate to their circumstances,” Bernanke said. For some time, the vulnerabilities created by allegedly misaligned incentives and product complexity in the mortgage market were largely disguised so long as home prices continued to appreciate. But lesson learned: “We should be wary of complexity whose principal effect is to make the product or service more difficult to understand,” Bernanke said. “Innovation, at its best, has been and will continue to be a tool for making our financial system more efficient and more inclusive,” Bernanke said. “But, as we have seen only too clearly during the past two years, innovation that is inappropriately implemented can be positively harmful.” Write to Kelly Curran at kelly.curran@housingwire.com. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments.

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